Review of price theories

Price theories have evolved along with economic development. From classical economics to today’s various schools of economic theories, theoretical research has moved from simple descriptions to applications of geometric and mathematical tools and has gradually established modern price theory, which is based on equilibrium analysis as the main methodology. The core content of the theories has evolved starting with Marshall’s partial equilibrium, moving to Walrasian general equilibrium, and culminating with disequilibrium theory.

Equilibrium vs. disequilibrium price theory

Marshall (2009) was the first to link the equilibrium approach of classical economics to utility and cost theories establishing the theoretical foundation for neoclassical economics. The core of Marshall’s partial equilibrium theory is equilibrium price theory. When analyzing the demand and supply relations and the price of any commodity, equilibrium price theory abstracts out the effects of other commodity prices as well as the demand and supply relations on the commodity in question. Moreover, equilibrium price theory argues that changes in any single commodity’s demand and supply are only determined by the change in that commodity’s price. Total market demand is the sum of all demand of every participant; thus, it is the total market supply. When market demand equals market supply, each consumer and producer attains their desired demand and supply, and the price is the equilibrium price. If demand or supply changes, the market mechanism of demand and supply will automatically adjust the price to restore the equilibrium. Marshall’s partial equilibrium theory is a pioneering research on the price mechanism and establishes an analytical framework for the perfect competitive market. The theory incorporates demand and supply functions, production costs, and marginal utility theory. In addition, the theory analyzes the impacts of effective demand, effective supply, and money on price. In particular, by introducing the concepts of elasticity and utility, mathematical methods can analyze price changes. However, partial equilibrium is a particular market case. The theory abstracts out the interactions and inter-dependency among different markets and among different products in the analysis, but society is an integrated system with inter-dependent elements. Therefore, the theory has flaws and limitations.

The Walrasian general equilibrium theory is an improvement. General equilibrium theory assumes that demand, supply, and the prices of all goods are interdependent and interactive in a society. The theory is based on marginal utility and investigates the issue of price determination from the perspective of the behavior of microeconomic subjects when the demand and supply of goods reaches equilibrium. The theory also adheres to the necessary conditions for a set of equilibrium prices. Although the Walrasian general equilibrium is, in theory, a complete and full exposition, its solution for the equilibrium is under the conditions that equations are linear, independent, and unconstrained. When the equations are nonlinear, or the system has additional constraints, there is no guarantee of a single solution. Moreover, in general equilibrium theory, all consumers and producers are price takers; moreover, demand and supply are infinitely elastic under a given market price. In other words, the market is perfect competitive. However, the reality is that demand and supply are rarely equal. The disequilibrium between demand and supply is a regular state in reality. Therefore, since the 1960, Patinkin (1984) and others have suggested the disequilibrium theory based on dynamic analysis.

The disequilibrium theory analyzes the problem of involuntary unemployment. The theory argues that involuntary unemployment is a disequilibrium phenomenon resulting from insufficient effective demand that puts quantity constraints on business production. Thus, the market supply is not controlled by price but by quantity. Clower (1986) analyzes household behavior under disequilibrium and notes the difference between demand and supply in theory and in reality. When households cannot supply labor according to their own wishes, the reduction in household income constrains their demand budget. Thus, it is not price but the excess supply in the labor market that leads to excess supply in the goods market.

Disequilibrium theory changes the binary analysis in the general equilibrium and has some unique features. First, disequilibrium discusses economic uncertainty and argues that the future is unknown, and the information that economic subjects can obtain is limited. Second, market resources are not fully utilized, and the market is not always in equilibrium. Third, in demand functions, price is no longer the only variable that affects purchase; income is an influencing factor. Fourth, in price analysis, the theory considers the interactions among the money market, labor market, and goods market as well as their effects, rather than analyzing only the goods market. Disequilibrium theory introduces the concepts of effective demand and effective supply; that is, the total trading volume of each commodity equals the minimum value in a pair of total demand and total supply. Therefore, it is not possible to make infinite exchanges at the market price. Every subject will perceive the quantity constraints on the maximum level of purchase or sales that they can achieve. If there is market scarcity, the formation of the equilibrium price will no longer be determined by demand and supply. There will be price makers and price takers in the market. The former will estimate the impact of their pricing decisions on sales (or purchase) through a perceived demand (or supply) curve. Of course, the actual parameters of the demand curve depend both on consumer behavior and on the pricing strategy of the price makers’ opponents. However, the price makers do not have full information, so their assessment of the opponents has uncertainty. Therefore, if the market demand and supply are in disequilibrium, in the short run, the actual transaction price will not be the same as the price under a full Walrasian equilibrium.